The impact of the April 2014 tax hike has been harder on economic activity than initially expected. Japan’s policy authorities are now starting to ease policies in order to boost growth.

As 2014 came to an end, it was clear that the impact of the April 2014 tax hike was harder on economic activity than initially expected. Annualized real GDP growth for the third quarter was revised down by 0.3 percent to -1.9 percent due to weaker fixed investment. Earlier, the economy had shrunk by an annualized rate of 6.7 percent in real terms in Q2 2014, which implies that the economy fell into a technical recession by Q3 2014.

Ongoing efforts to get the economy out of deflation that has lasted a decade-and-a-half have been adversely affected by the recent sharp drop in oil prices. Consumer price inflation slipped to a 17-month low of 0.4 percent in November, after accounting for the effect of April’s tax increase (which added 2 percent to inflation from May onward). Core consumer price inflation was merely 0.7 percent in November, down from 0.9 percent in October 2014. While the Bank of Japan (BOJ) expects inflation to reach the 2 percent target rate in the next six months, its quarterly survey showed that most companies forecast a weaker rise in output prices in December than they expected in October.1

Poor economic performance and falling investors’ confidence in Japan’s ability to pull itself out of deflation have raised several questions about the success of Japan’s much-heralded, three-pronged Abenomics.

Poor economic performance and falling investors’ confidence in Japan’s ability to pull itself out of deflation have raised several questions about the success of Japan’s much-heralded, three-pronged Abenomics. Until Q2 2014, the economy responded positively to the first two arrows of Abenomics, which involved easy monetary and fiscal policies to boost the economy. However, post the tax hike in April, the economy started faltering. Although recent monthly data on retail sales, the industrial production, and exports suggest that the economy may exit recession in Q4, the growth outlook for the quarter remains grim.

Rapid policy actions

The policy authorities of Japan are now rapidly shifting gear to ease policies in order to boost growth. Following the release of the Q3 GDP numbers, Prime Minister Shinzo Abe called for an immediate snap election in November and decided to delay the consumption tax increase by an additional 18 months. The cabinet also approved a new economic package of 3.5 trillion Japanese yen to revitalize the economy. The stimulus is expected to provide some relief to consumers, who have been facing spending constraints due to the rise in taxes, and thereby boost consumer spending. A third of the proposed package is designed to assist small businesses and households, whose real income has been affected by the declining yen and increasing input costs. In addition, the stimulus is aimed at boosting Japan’s local economies, infrastructure, and public works.

The government is also trying to persuade domestic companies to raise wages and boost investment spending by reducing corporate taxes. It recently announced that the corporate tax rate would be cut by 3.29 percent over the next two years and that it intends to gradually reduce the tax from the current rate of 34.6 percent to below 30 percent over the next five years.2 Companies in Japan have record cash holdings worth 233 trillion yen. Economic uncertainties and poor domestic demand have dissuaded these companies from increasing business spending or raising wages. The government is hoping that these incentives will motivate companies to spend more.

Earlier in October, the BOJ stepped up quantitative and qualitative monetary easing. The BOJ governor surprised the financial market by announcing that the bank will increase its asset purchases each year from 60–70 trillion yen to 80 trillion yen.3

The government ended the year with expectations that it will engage in structural reforms aimed at boosting productivity in 2015. The combination of aggressive monetary and fiscal policies, together with the postponement of the tax increase, resulted in further depreciation of the yen, while the equity index soared by the end of 2014. Depreciation in the domestic currency is expected to raise the economy’s export competitiveness, while rising equity may boost investors’ confidence.

Growth outlook for 2015

In 2015, the performance of the economy will likely depend, in part, on whether Abe goes ahead with his much-discussed reform agenda. The ruling coalition won a majority in the parliamentary election in December, giving Abenomics another chance to revive the economy. The implementation of the policies is only halfway through, and a lot more needs to be done to win investors’ confidence. The recent win may help Abe to push ahead politically unpopular economic reforms.

Additionally, a number of factors will likely influence growth, such as the monetary policy stance of the BOJ, the government’s approach to fiscal consolidation, the pace of growth among Japan’s important trade partners and the resulting foreign demand for its exports, the willingness of businesses to increase investment, and the shrinking workforce.

The BOJ will likely maintain its asset purchases through 2015 to prevent the economy from sliding back to deflation. Monetary easing will likely help reduce interest rates, boost the money supply, and depreciate the domestic currency further. The decision to delay the second tax hike will shift the negative impact of fiscal tightening on growth, which implies that there might be an upward revision of GDP projections for 2015. Poor growth and lower investment in China may hurt Japan’s exports because the former is the biggest trading partner of the latter. However, stronger growth in the United States and a modest recovery in some of the EU regions may partially offset the impact of slowing growth in China.

One of the biggest near-term challenges will be to revive business investment as the economy continues to contract. Unless companies start investing their idle cash to build capital, expand operations, engage in new businesses, and boost wages, growth momentum will likely remain slow. On the other hand, Japan’s shrinking workforce will likely cause the biggest long-term drag on the economy; the number of births hit an all-time low in 2014. While increasing women’s participation in the labor force might offset the impact of a declining population for some time, in the long term, demographic pressures will significantly affect economic growth.